The Profit Paradox

by Greg Satell

A business that doesn’t make money won’t be around for very long. Profits, after all, are the engine that drives the world of commerce. Any idiot knows that.

Unfortunately, idiots who do know that go out of business all the time. The US auto industry, integrated steel giants and many others who failed were extremely profit driven and, in fact, it was their quest for profits that was their undoing. That’s because making money means nothing without competitive advantage. Companies who chase opportunities in the name of profitability often find they can’t compete, while others, like Wal-Mart, Southwest Airlines and Nucor are able to be consistently profitable in tough industries with thin margins. Profits aren’t always what they seem.

The Difference between Economic Profit and Making Money

True profitability is more than just making money, although the two concepts are often confused. Richard Rumelt illustrates the point nicely in his book Good Strategy/Bad Strategy, where he gives the example of an imaginary silver machine.

He asks us to imagine a silver machine dropped from a UFO that can create $10 million dollars of silver per year out of thin air with no costs. There are also no taxes and the interest rate is 10%. A profit seeking company buys it for $100 million. Did they make a good investment?

The not so obvious answer is no. Their return on the silver machine was 10% – exactly their cost of capital. There’s no way for them to improve on the machine, it already produces silver at no cost. They might be betting on the increase in silver prices, but then they aren’t creating any value, just investing in a commodity and hoping it will go up and not down.

It’s a very simple concept, but one that few managers understand. You are only truly profitable if you earn money in excess of your cost of capital, otherwise, you’re better off with money in the bank (unless, of course, they are chasing their own profits in real estate), and the only way to consistently do that is to build advantage.

When a country earns lots of money from selling commodities, it does more than just bring in money. It also drives up wages and currency values. Generally, that’s a good thing, but it also has a downside. Products in high skill, value-added industries become uncompetitive.

Many corporations fall into a similar trap. They see a high growth industry and rush to get in on the windfall. Of course, other companies see the same opportunity and do the same. Investments are made, salaries go up (labor tends to be scarce in high growth industries) and focus shifts.

Inevitably, growth in the target industry slows and by that time there is overcapacity from all the companies rushing in. The “great profit opportunity” has done nothing but take resources from the core business.

Shrinking to Greatness

In his groundbreaking book, The Innovator’s Dilemma, Harvard professor Clayton Christensen described how incumbent companies often respond to industry disruptors by migrating upward, with disastrous consequences. He gives the example of integrated steel companies response to the disruptive technology of mini-mills like Nucor.

At first, the mini-mills main advantage was in the low-grade steel used to make rebar. The big steel makers happily conceded the market and focused on more premium, higher value added steel which had higher margins. And why not? Their profits and productivity increased, their stock went up and the business press lauded management who earned millions in incentive pay.

The story, of course, didn’t end there. Over the next 20 years, minimill technology steadily improved and migrated upward. In each case, Big Steel retreated to higher value products and increased profitability until there was nowhere else to go. Bethlehem Steel went bankrupt in 2001 and National Steel filed in 2002. Nucor is still thriving.

Deepening Advantage & The Flywheel

By any measure, Southwest Airlines is a very successful company. They’ve had 38 consecutive years of profitability in an industry that spews red ink. Southwest is hailed for their superior model, but the funny thing is, it isn’t really theirs. As Jim Collins reports in his book Great by Choice they copied it, manuals and all, from Pacific Southwest Airlines.

Never heard of Pacific Southwest Airlines? That’s because they’re not around anymore. In 1968, they sought to earn greater margins through diversifying into hotels and car rentals (a strategy they called Fly-Drive-Sleep) and then when that didn’t pan out they decided to try out long haul flights. Having failed in both ventures, they were eventually bought out by USAir.

Southwest, on the other hand, deepened their model, honing each part of their system. The cumulative effects of small improvements made over the years have built a money making machine. In much the same way, Wal-Mart has achieved advantage through their logistics system painstaking assembled over decades.

Collins calls this the “flywheel effect” and he contrasts it to the “doom loop,” where managers seeking quick profits get into businesses they shouldn’t. Having run many businesses myself, I see what he means. It always seems like somebody somewhere else is making money easier, but the true route to profitability is to build advantage over time.

Creating Sustainable Advantage Through Thick Value

I earlier wrote about the difference between thick value and thin value. Thin value might bring in money for a while, but it’s merely a transfer from one entity to another, like telecom companies who add extra instructions to voicemail so that consumers use more minutes. That creates value for the business, but only by taking it from the consumer.

Thick value, on the other hand, creates value for society. Companies like Southwest and Wal-Mart do it by being so efficient that they save us money. Apple and Google have created new products that enrich our lives. Whenever you see a long track record of success, you’ll find thick value created.

And that’s the profitability paradox. Businesses who profit without purpose will ultimately end up with neither (unless, of course, they have very good industry lobbyists). Companies infused with purpose, on the other hand, will have the passion to seek out the think type of value that confers advantage.

No comments

It is interesting to see the profit paradox addressed so clearly and broken down into different types of examples. This has renewed my interest in Dutch disease as it is the one I had some trouble understanding, the wiki link helped there. A narrower and more detail article would not appeal to as many people. But I wonder how the size of the company comes into play with the profit paradox. Primarily with small or new businesses on how to mitigate these risks especially with outside pressures that seem be counter productive.